Halogen is a Canadian-based software company, trading on a Canadian exchange, selling talent management software to mid-sized companies, primarily in the U.S. Later in the letter, we discuss the importance of simple math. In the case of Halogen, part of the simple math relates to currency conversion. Halogen’s share price is denominated in Canadian dollars; with today’s exchange rates, a Canadian dollar equates to around 80 U.S. cents. Other than share price, every other number for Halogen – including cash on the balance sheet and revenues – is valued in U.S. dollars.

When converting the currency properly (not clear that everyone does this basic math correctly), Halogen has just about the lowest Enterprise Value (Market Cap less Cash)/ Revenue of any company we know of that is not facing some sort of terminal decline. Specifically, at $7 (CAD) – where we bought a lot of additional shares – the company had an EV of less than $85M USD and revenue (growing 10%+) of $65M, so it was effectively at an EV/Rev of 1.3X when SAAS companies will typically trade anywhere from 2X-8X depending on growth rates, margins and the competitive landscape. We would typically focus on cash flow, but in the case of a growing SAAS software company with strong unit level economics (positive lifetime value of a customer), sales and marketing to acquire even more customers is expensed immediately (not capitalized) and distorts the Price to Earnings and Price to Cash Flow metrics. The valuation is not demanding.

The largest problems with Halogen are that customer acquisition costs have risen and growth has slowed. By my estimates, which I shared with management, Halogen is paying approximately $55K to acquire each new customer, but the company was only being valued at less than $40K per existing customer when using the public market enterprise value/# of customers. My argument to management was that it is cheaper to buy back stock than go and acquire new customers. The company has since put in place a large buyback for 1.2 million shares (5% of the outstanding shares), and fortunately, given the large cash balance, Halogen can buy back shares and still acquire new customers.

The new CEO is outstanding and has embraced a partnership model to acquire customers more efficiently. I think he is making very sound decisions and look forward to the progress the business makes. The combination of a low multiple and improved marketing efficiency could be a powerful catalyst for future returns. The HR software space is undergoing consolidation as companies go from offering piecemeal solutions, such as payroll, benefits management, or talent management, to offering a complete suite of solutions. Given the current valuation, the corporate overhead that could be stripped out by an acquirer, and the lowered customer acquisition costs if folded into a larger company with an existing customer base to sell into, the economics for an acquirer would make sense even at twice today’s share price.

Scott Miller is an instructor at Wide-Moat Investing Summit 2016.

[us_separator]

This post has been excerpted from the Greenhaven Road Capital Q1 2016 Letter.

Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Greenhaven Road Capital Fund 1 LP and MVM Funds makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors, appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Greenhaven Road Capital Fund 1 LP and MVM Funds. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Greenhaven Road Capital Fund 1 LP and MVM Funds, which are subject to change and which Greenhaven Road Capital Fund 1 LP and MVM Funds do not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption thereunder. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.